A taxpayer came to me looking for a second opinion on how his company's 2011 and 2012 IRS Form 1120-S were prepared, signed and filed because the retained earnings reported on Schedule L was ($100,000) - as in negative - AND the Accumulated Adjustment Account (AAA) on Schedule M-2 was also reported at ($100,000) as well.
The taxpayer and his wife each owned 50% of the corporation's shares outstanding. In 2012 each shareholder took a distribution of $150,000 causing a retained earnings reduction to ($400,000) while the AAA or Schedule M-2 remained at ($100,000) and ultimately the taxpayers were concerned that their tax guy wasn't completely confident in his reporting for either year.
Aside from the fact that perfectly round 6 digit numbers on ANY tax return look suspicious to me there were a few other lessons that could be taken away from working this file:
1. For S-Corps IRS Form 1120-S Schedule M-2 Accumulated Adjustment Account (AAA) does not necessarily need to match IRS Form 1120-S Schedule L mostly because Schedule M-2 is not a reconciliation of equity.
2. Schedule M-2 is based on IRC §1.1368-2(a)(3)(iii) which precludes any entry below zero if reduced to that point by distributions.
3. Most astute IRS examiners are RARELY concerned if AAA is different from retained earnings on the 1120-S. Back in the day the Internal Revenue Manual had a chapter - 188.8.131.52.2(3) - to be exact which at the time specifically stated:
"The main difference (between retained earnings and AAA on the 1120-S) will be (due to) timing differences between book and tax (reporting obligations). For example, if the book depreciation is less than the tax depreciation, the retained earnings account on the balance sheet will be larger than the AAA balance."
The Internal Revenue Service deleted this chapter of the Internal Revenue Manual outright since but the general gist is the same. Retained Earnings and Line 1 of the M2 really only fail to tie as a result of timing issues.
4. Retained earnings however is a concept based on the basic accounting equation where assets = liabilities + equity and serves in part as a reconciliation of equity.
5. For the purpose of simply matching the AAA to retained earnings the taxpayer really does not need to worry too terribly much as this is one of many fundamental ways that the 1120-S is treated differently from the 1065 or the 1120.
However almost immediately the biggest concern I had was whether the taxpayer had enough basis to support the distributions and how that basis was tracked because in the absence of basis a gain will need to be recognized for tax purposes.